Does it make sense to take out student loans to start an IRA?

Let’s say you’re an undergraduate student, and you’re eligible to take out more money than you need to pay for school expenses (at a fixed interest rate of 4.66%). Due to compounding, it’s always best to start investing for retirement as early as possible. Does it make sense to take out the maximum allowed, dump the excess into a retirement account like an IRA, and then pay it back later when you’re working (contributing less to retirement at that point so you can pay off the loan faster)?

Bonus question: Is there a difference if I instead take out the loan to pay for educational expenses I could afford on my own, then stuff my own money that I earmarked for education into an IRA?

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4 Responses to “Does it make sense to take out student loans to start an IRA?”

I’d check the terms of the student loan. It’s been a long time since I had a student loan, but when I did it had restrictions that it could only be used for educational expenses, which they pretty clear spelled out meant tuition, books, lab fees, I think some provision for living expenses.

If your student loan is subsidized by the government, they’re not going to let you use it to start a business or go on vacation … nor are they likely to let you invest it.

Even if it is legal and within the terms of the contract, borrowing money to invest is very risky. What if you invest in the stock market, and then the stock market goes down? You may find you don’t have the money to make the payments on the loan. People do this sort of thing all the time — that’s what “buying on margin” is all about. And some of them lose a bundle and get in real trouble.

IRA contributions are limited; you cannot “dump the excess into a retirement account like an IRA” if the excess is more than $5500. Furthermore, as @firefly points out, you need to have earned income (technical term is compensation and it includes self-employment income, not just wages) to contribute to an IRA, and the limit mentioned above is actually the lesser of your earned income and $5500.
(There are other limitations for people with high gross income, but these likely will not affect you)

On the positive side, if your earned income is small, you can contribute your entiretaxable earned income
including the money withheld by your employer for Social Security and Medicare tax and Federal, State and local income taxes to an IRA, not just your
take-home pay. For example, if your earned income is $5500 and take-home
pay after tax withholding is $5000, you are still entitled to contribute
$5500. So, where do you get that withheld money from so that it can be
put into your IRA? Well, it can come from the student loan or interest earned
from a bank or from the
dividends and capital gains on your investments, etc. Money is fungible;
it is not the case that only the cash received (or deposited into
your bank account) as your take-home pay can be contributed. Subject to
other limitations mentioned, your earned income can be contributed, not
just your take-home pay.

Note: I will not address the legal aspect of the question. If you can or not use Federal money to invest.

1st – Investments with Student Loan

Usually student loans are to invest in your future by improving your chances of getting higher returns (Salary or other) due to your preparation. However, if you are smart enough now to take a 4.66% interest loan, and invested in a way you will get more than 4.66%, then I would say it makes sense.

2nd – IRA as the Instrument

IRAs are really good instruments to reduce your tax obligation, increase your retirement comfort, and invest in many thins with a few exception (assuming you could use a self-directed IRA). However, answering if it makes sense should be answered by analyzing your income, your taxes, and where are you planning to invest with that IRA.

A ROTH IRA might be a good idea in case you want to withdraw the investment and pay the loan without getting penalized, or even put it back for education if you ever realized that you have not done smart investments.

Depending on the student loan, this may be improper usage of the funds. I know the federal loans I received years ago were to be used for education related expenses only. I would imagine most, if not all, student loans would have the same restrictions.

Bonus Answer: You must have earned income to contribute to an IRA (e.g. money received from working (see IRS Publication 590 for details)). So, if your earmarked money is coming from savings only, then you would not be eligible to contribute. As far as whether you can designate student loans for the educational expenses and then used earned income for an IRA I would imagine that is fine. However, I have not found any documentation to support my assumption.